When an investment passes our first-screen at Meritage Funds, the first deep-dive we typically do is on the unit economics of the business. Unit economics are the fundamental financial building blocks of a business. If you can pin down the unit economics, you can determine contribution margins, break-even points and perform ROI calculations all of which can help to determine whether a Company’s economic engine works. Without an understanding of unit economics, predicting whether a business can be profitable in the long-term is all guess-work.
I’m a believer that every business – no matter the scale – should have a point of view on its unit economics. That includes you startups. However, the concept is not as easy to apply as most hope and is frequently mis-applied. Here are some basic principles I use when thinking about unit economics.
What is your unit?
The following is a master of the obvious statement; building unit economics requires you to first pick the unit. I recommend picking a unit at which the company has its most significant level of marginal investment.
For example, for consumer focused businesses the best unit is typically as single customer. The investment at the customer level is customer acquisition cost (CAC) and for businesses that deliver a physical good, the cost to deliver the product. A customer-level unit also typically works well for enterprise focused businesses.
Some businesses require multiple unit measures. For example, an infrastructure service provider that has a geographically distributed physical infrastructure (data centers, cloud, wireless towers, etc.) have significant marginal capital investment for each new deployment. As a result, these businesses should use each unit of physical infrastructure as their core unit and within each, use a customer unit as a secondary unit.
Key unit economic model assumptions
Identifying the level of unit economics is the easy part. Getting the calculations right is a different matter. On the outflow side, the inputs are:
- Capital Expenditures: The up front capital cost to create the unit. For an infrastructure style unit economic model, this would be the capital expenditures required to build the unit.
- CAC: The initial, pre-revenue cost to acquire a customer. For a customer unit economic model, this is the fully loaded customer acquisition cost, including variable sales, marketing, and implementation costs that can be directly attributable to customer acquisition and on boarding.
- Marginal Operating Costs: This is the ongoing marginal cost to serve the customer or to operate the infrastructure over the life of the unit.
- Maintenance CapEx: Physical assets degrade over time. As a result, for an infrastructure business, it is important to factor maintenance CapEx into the unit economic model. This is the amount of CapEx required over time to keep the infrastructure operating at a suitable service delivery quality.
On the in-flow side, the inputs include:
- Revenue: No need to explain, although I do advocate that companies put together a fairly detailed set of revenue drivers in their unit model; a topic for a different post.
- Duration: When building a unit economic model, it is important to know the usable life of the unit. In an infrastructure model this is the useful life of the asset, factoring in the maintenance CapEx. In a customer unit model, this is the average customer life. Duration or Average Customer Life in a customer-driven unit model is the flip-side of churn-rate, where the relationship between the two is captured by the following equation:
1/churn rate = average customer lifetime
It is important to note that the average customer lifetime will be in whatever time period you use for your churn rate. Input a monthly churn and get a customer life in months. The churn rate required for this calculation is a customer count churn rate, as opposed to a revenue churn calculation. I could spend several posts solely on how to calculate churn.
- Growth/Decline: You may believe that revenue per unit will increase or decease over time. This is critical to reflect in your unit model.
Each of the inputs require their own set of calculations. Setting aside the details, what we’re driving toward is a unit economic model that helps us perform some business model viability calculations.
Does your unit hunt?
Once I have the unit economic model inflows and outflows set, I like to lay them out in a time series, showing each inflow and outflow on its own line item. Sum them all up and you get to contribution margin. Contribution margin is the amount of cash that a unit contributes to covering corporate overhead expenses. I look at is the number of months it takes for the unit to produce a positive contribution margin and the number of months it takes for the unit to return whatever up-front investment that was required to produce it. The month in which a unit generates a cumulative positive contribution margin is the payback month.
With some additional math you can calculate the number of units that are required to bring the entire business to profitability. To do so, simply divide the company’s fixed overhead by the unit contribution margin. Finally, for capital-intensive businesses, particularly infrastructure businesses, it may be useful to calculate a return on investment for a unit.
Again, each of these calculations has its own set of detailed mechanics behind it. The point I want to make here is that you can’t begin to know whether your business economic engine works until you’ve built a unit economic model. If you are considering raising growth capital, start building your unit economic model today. You’ll be thankful you did the work when a prospective investor asks to see it. Any growth stage investor worthy of investing in your business will surely ask.