Unit economics are critical to successful business growth. Without positive unit economics, spending more money means you simply lose more money.
However, when it comes to two-sided marketplaces, It’s Complicated™. I’ve seen experienced analysts admit defeat when trying to get to grips with our unit economics at Wonolo.
Here I aim to walk you through the topic step-by-step, in two parts. No prior knowledge is assumed.
Part 1: Unit Economics Basics
I want to provide a gentle learning curve. Before we talk about two-sided marketplaces in Part 2, let’s first quickly cover some basics. If (like me) you don’t have a formal background in finance, you may struggle with some of the terms used.
Disclaimer: because I’m assuming no prior knowledge, some complexities are overlooked for simplicity.
If you already know all this, feel free to skip straight to Part 2: Unit Economics in Two-Sided Marketplaces.
What’s a “unit”?
Ok, we’re talking about “unit economics”; so, what’s a unit?
For me, the confusion starts right here. As the name implies, a “unit” might originally have referred to a widget made in a factory. For example, if we run a factory that makes paperclips, unit economics relates to understanding the economics of paperclip production and sales, down to the level of an individual paperclip.
However, in the context of startups, we typically have one product and we’re selling access to that product. The “unit” we’re interested in modeling is the act of selling access to a user or customer.
Therefore, a “unit” is typically equivalent to a customer or user. As we run through these basics, you can think of our “unit” as a customer.
Variable vs Fixed Costs
The first core concept to understand is the distinction between “Variable” and “Fixed” costs.
- “Fixed Costs” remain the same, however much you sell.
- “Variable Costs” vary depending on how much you sell. If you sell nothing, Variable Costs are zero.
When looking at Unit Economics, we’ll mostly be interested in Variable Costs.
Introducing our Lemonade Stand
I’m going to use a Lemonade Stand as an analogy. It’s a simple but sometimes flawed analogy. (If nothing else, it presents an opportunity for some heart-warming pictures.)
For our lemonade stand:
- “Fixed Costs” would be the costs of renting and operating our lemonade stand, and the pay for the person running the stand. They stay the same whether you sell 100 cups of lemonade or 0 cups. (Ok, I wouldn’t normally pay my kids to run a lemonade stand but this is just an analogy.)
- “Variable Costs” would be the costs of the lemons, sugar, and water to make the lemonade. They vary with how much lemonade you sell.
Customer Acquisition Cost (“CAC”)
The first of many TLAs (Three Letter Acronyms) is “CAC” or Customer Acquisition Cost. This is what it costs you to acquire one customer.
The most obvious and common costs included in CAC are marketing costs.
There are various accounting practices and standards that determine what else is or isn’t included in CAC. For example, in some cases, CAC may include all or some part of the compensation paid to people directly involved in selling to customers.
[Don’t confuse CAC (Customer Acquisition Cost) with COGS (Cost of Goods Sold) – they are related and may essentially be the same in a simple software business but CAC is the important consideration in our unit economics analysis.]
Our Lemonade Stand
Let’s say we print fliers to advertise our lemonade stand.
These cost $1 each to print and each one brings 10 customers to our stand.
Our Customer Acquisition Cost (CAC) is $0.10 [$1 / 10].
Our next TLA is “LTV” or Life-Time Value. This refers to how much money you’ll make from each customer, on average, during their entire time being your customer.
LTV is often difficult for startups – especially in the early stages – because you don’t have enough data. For example, perhaps customers will stay on average 2 years or 10 years but, if the startup is only 18 months old, you don’t know yet.
However, as the company ages, you’ll start to see the average customer life-time level off (or “asymptote”) to a certain value.
A complication here is that LTV can either be discussed as “Gross LTV” which is simply the money you get paid by the customer, or “Net LTV” where the variable costs have been subtracted.
Net LTV will typically be much lower than Gross LTV. If you want to look good, use Gross LTV. If you want to really understand your Unit Economics, use Net LTV.
Our Lemonade Stand
We’re going to charge 25 cents for a cup of lemonade. Our stand is only open for 1 month during the summer (and only this year).
On average, each customer buys 4 cups of lemonade. Therefore our customer LTV is $1 [4 x $0.25].
By dividing the average Lifetime Value (LTV) of a customer by the average cost to acquire a customer (CAC), we get the LTV:CAC ratio.
This is a simple measure of the efficiency of our business model – it measures how much more money you get back from each customer versus the cost to get the customer.
Our Lemonade Stand
So, our LTV is $1.00, and our CAC is $0.10, so our LTV:CAC ratio is 10:1. Pretty good.
Our third TLA is “MRR” or Monthly Recurring Revenue. This is the average amount of money you get each month, from each customer.
MRR is very commonly used for SaaS companies since they tend to have fixed and predictable income from each customer, based on monthly billing of a fixed amount. e.g. $9.99/month, paid every month until you cancel the service.
As we’ll see later, marketplaces can have very different dynamics and MRR can be a much less useful measure. I’m including it here because it is very commonly used in the context of unit economics and provides a simple way to explain some of the following concepts.
As discussed above, the LTV:CAC ratio provides a simple way to understand the efficiency of a business model by comparing the money you make from each customer against how much money it costs to get them.
However, LTV:CAC ignores the time dimension: in many cases, you bear your CAC upfront but you only receive payment from the customer over time.
The Break-even Point refers to how long it takes a customer to “pay back” what it cost you to acquire them (the CAC).
This chart shows a simple example of a company with a $500 upfront CAC and a fixed $50/month MRR. (i.e. a customer costs you $500 to acquire and pays you $50 per month for your services.)
As you can see, it takes 10 months to break-even in this simple case [$500 / $50].
Break-even Point is important because it determines how fast you can grow your business. While you’re waiting for a customer to “pay back” their CAC, you can’t use that same money to do anything else, like acquire more customers. (In finance terms, it impacts your “working capital”.)
So, the shorter your Break-even, the better.
Once you break-even on a customer, you’ve got your money back, and you can rinse-and-repeat. However, while you’re waiting to get your money back, your speed of growth is limited – you can’t grow any faster without more working capital.
One way to get more working capital is to raise more money from investors. With this money, you can spend it on acquiring more customers while you’re still waiting for your earlier customers to pay back their CAC.
The downside of this from a founder’s point of view is that you have to sell part of your company to raise more money, of course. The downside from an investor’s perspective is that they will have to keep putting more money in to increase the rate that you grow.
Therefore, it’s good to understand the CAC-doubling Point. This is the point in time where you’ve not only recouped the original CAC, but also earned enough to acquire another customer – i.e. 2x the CAC. Once you’ve got 2x your CAC back, you can continue to accelerate your growth without having to raise any more money from investors.
Simply put: your CAC-doubling point tells you how quickly one customer pays you enough to acquire another customer.
One of the biggest limitations on customer life-time value (LTV) is typically churn – i.e. losing customers.
To understand the impact of churn on your Unit Economics, you need to understand how frequently you lose customers (churn rate) and how much money they’ve spent with you on average before you lose them.
If they churn before paying back what it cost to acquire them (CAC), then you’re going to lose money – your unit economics are negative and the more you spend to acquire customers, the more money you lose.
Marginal Operating Costs
Often there are ongoing costs associated with servicing a customer after you’ve paid your CAC to acquire them. Typical examples would be support and service/maintenance costs. Such costs are referred to as “Marginal Operating Costs”.
This is an area where finance conventions can differ but it’s easiest to think of Marginal Operating Costs as Variable Costs that occur over time.
From the perspective of Unit Economics, it’s important to understand the impact of Marginal Operating Costs on your Break-even Point.
The below chart shows the same $500 upfront CAC and $50 MRR but, this time, we’re adding a $20 marginal operating cost each month.
As you can see this pushes back the Break-even Point from 10 months to about 17 months. [$500 / ($50 – $20)]
Our final basic Unit Economics term is “Contribution Margin”. This refers to how much of the company’s fixed costs are covered by the revenue from customers, once the variable costs have been taken out.
Personally, I find the term confusing in the context of startups.
“Contribution Margin” is the contribution (hence the name) of a single product towards the company’s overall margin, whereas terms like “Gross Margin” refer to the company as a whole. i.e. if you sell only one product (like most startups), contribution margin and gross margin are essentially equivalent.
Contribution Margin is most often discussed as a ratio – “Contribution Margin Ratio”. It is simply the revenue divided by the revenue minus variable costs. Again, if you have one product only, “Contribution Margin Ratio” is equivalent to the % margin for the business as a whole.
Going Beyond Unit Economics
The ultimate objective is that, over time, your Contribution Margin (or margins, if you have more than one product) will be enough to cover all of your Fixed Costs.
At this point, you can think of your business as “profitable” as a whole, in colloquial terms – enough money is coming in to cover all of your costs (variable and fixed). In accounting terms, we’d also need to consider any costs related to taxes, interest on loans, etc before we can call it truly “profitable”.
Scooter unit economics: a Cautionary Tale
Now let’s take a look at a cautionary example in recent history.
In 2018, rental scooters suddenly appeared on our streets. Bird, for example, raised a $100M Series B and a $300M Series C – both in 2018.
So, scooter rental must be a great business, with great unit economics, right?
Let’s look at the unit economics of scooters:
- Acquiring customers was not hard – people were literally tripping over them on the sidewalk (and complaining about it). So, for the purposes of this analysis, let’s say rider CAC was essentially $0.
- It cost about $500 to buy one of those first-generation scooters.
- Each scooter made about $500 per month in revenue.
- The Marginal Operating Costs – charging, relocating scooters, etc – were about $200 per month.
So a Contribution of Margin of about $300 per month, per scooter. You can pay back that $500 purchase cost in less than 2 months. Pretty good business?
You may remember what happened: people didn’t treat the scooters kindly. The average scooter lasted about 28 days, so it wasn’t possible to recover the $500 upfront purchase cost before the scooter was destroyed, and the unit economics didn’t work.
The other thing that happened was injuries and subsequent lawsuits. A big proportion of scooter injuries were nasty head injuries, meaning big payouts for the scooter companies.
The huge amount of investment the scooter companies garnered was enough to maintain these losses for a while but ultimately a few things happened:
- Scooter companies tried to source more resilient scooters, with higher longevity to get to breakeven on each scooter (compare how solid current  scooters are with the first-generation 2017 Bird scooter).
- Uber/Lyft acquired scooter companies – although the unit economics of scooters were poor, they provided a great way for ride sharing companies to acquire riders, and more cheaply. By becoming scooter chargers, it also allowed Uber and Lyft to offer additional income generation for their drivers.
- Some scooter companies pivoted to electric bikes – much lower injury rate, much higher longevity, and much better unit economics.
The lesson of this story is that initial, quick takes on businesses can be misleading – you need to truly understand the unit economics.
Summary so Far
To recap, the core concepts we covered are:
- Fixed vs Variable Costs
- Customer Acquisition Cost (CAC)
- Life Time Value (LTV)
- LTV:CAC ratio
- Break-even Point and CAC-doubling Time
- Marginal Operating Costs
- Contribution Margin
Next, on to Part II: Unit Economics in Two-Sided Marketplaces…
One thought on “Everything You Always Wanted to Know about Unit Economics but were Afraid to Ask – Part 1”
Great intro, very clearly explained. Thanks for sharing.