by Naman Rastogi
13 / 04 / 2022
Any founder who has ever pitched to a VC would have definitely been asked this question - What does your unit economics look like?
Unit economics is the revenue and expense analysis of the company at its product/service level which is defined as a ‘unit’. So, whenever anyone is performing unit economics analysis, the first step is to identify the core product/service offered by the company. For example, in the case of Uber, the unit economics would be based on the no. of rides, in the case of a restaurant business, it would be based on the no. of orders, and in the case of a lending company, it would be based on the no. of loans disbursed, and so on and so forth.
Let’s take a look at the example of a modified annual P&L of a restaurant business to understand it better.
Revenue: $100 Mn.
COGS: $(50) Mn.
GM: $50 Mn.
Food Wastage: $(5) Mn.
CM: $45 Mn.
OpEx. (Staff salary and Rent): $(25) Mn.
EBITDA1: $20 Mn.
Marketing: $(10) Mn.
EBITDA2: $ 10 Mn.
Here, if we divide each line item by the no. of orders in a year, what we would have is unit economics! Why unit economics has become so important for a VC is because it helps in assessing the long-term sustainability of a business. For example, if the Contribution Margin/order is -ve in the above example, it means that the business would never be able to cover its fixed costs which are represented by OpEx. and Marketing, and hence the business is unsustainable.
Other important analysis that done at a unit customer level, and are equally important for a VC are as below:
Churn Rate: This is the percentage of total no. of customers lost over a period of say 1 year. This is calculated as the no. of customers lost during the year/total no. of customers at the beginning of the year. Another way of interpreting churn rate is in terms of average customer lifetime. For example, if the churn rate is 20%, the average customer lifetime is 1/20% i.e. 5 years.
CAC (Customer Acquisition Cost): This is the total marketing spend incurred to acquire a customer. Let’s say we acquired 10 customers this year, then, in the above example, our CAC would be $1 Mn.
LTV (Lifetime Value): This is the profit generated over the life of a customer. This is calculated by dividing EBITDA1 per customer by the churn rate. Assuming our churn rate is 20%, our LTV would be $1 Mn./20% = $5 Mn.
LTV/CAC Ratio: This is calculated by dividing the LTV with CAC which is 5x in this case. A good LTV/CAC ratio can be anywhere between 3x-5x, and it means that the EBITDA1 generated over the lifetime of a customer is 3 to 5 times the marketing spent on that customer and hence justifies the long-term sustainability of the business.
We at Fasanara Capital actively invest in FinTech and Web3 companies. If you are an early-stage company with an interesting product and a strong unit economics, do reach out to us through our Fasanara Seed Program