1 - Unit Economics

Hi. Here's a video on startup unit economics. In particular, the LTV to CAC ratio. LTV is the lifetime value of a customer. CAC is the cost to acquire a customer, and together they are the growth engine of your company. CAC is the money in, LTV is the money out. So how do you actually calculate these things? LTV is most often calculated by looking at the value of a customer in one period and then multiplying by how many periods you keep them for. Cac, on the other hand, is most often calculated by looking at the total expenditures of your company on acquisition in a given period divided by how many customers you got for those expenditures. So let's step through this with an example. Let's say we have a software startup that charges its customers $1,000 a month. Now, gross margin matters. In software, you might have a gross margin of 80%. In hardware, due to much higher cogs, your gross margin might be 20%. So for now, let's assume we have a SaaS startup and they're keeping a net revenue of $800 per customer per month. Now, how long do they keep customers for? You can use the churn rate for that. So let's say our startup has a 4% monthly churn rate. One divided by 4% means that we keep our customers on average for 25 months. $800 per month times 25 months means we have an average lifetime value of $20,000. Now what about the acquisition side? Let's say our startup spent $50,000 on forehead count in sales and marketing in June. Let's say the marketing team also ran $30,000 worth of marketing campaigns. That means there was $80,000 of total expenditures on acquisition. And let's say for those expenditures, we gained 10 new customers. That means that we have an average acquisition cost of $8,000 per customer. Now we're looking for a ratio. So in our example, we had $20,000 of LTV, $8,000 of CAC. So that's a ratio of 2.5. Is that high or is that low? There's a rule of thumb. So 0 to 1, you don't have a business. You're paying more to acquire customers than they're worth. Over three, you've got a good business. Over five, you've got a great business. Now, the most important thing about the LDV to CAC ratio is that it's a tool, just like a chainsaw. If you use it blindly, bad things will happen. So most importantly, the assumptions in the LTV to CAC are very sensitive. So for example, averages. If you take an average churn rate, but your churn rate is actually trending up or down, that will be a problem. And also composites. If you take a composite cost of acquisition, but yet you have very disparate campaigns, some of which will scale and some of which will not, all of which have different acquisition costs, that will be a problem. On the other hand, you probably need to use averages in some places. Like churn rate can be very spiky. You may need to use for example, a trailing three month average. So overall, the most important thing is to remember that it's a tool. And the first thing you need to do after calculating your LTV to CAC ratio is step back and look at the assumptions. Try and keep it simple. Don't overcomplicate, overcomplicate it with the dcf. Look at the assumptions and say to yourself, if these were different, if in our startup, this trend's higher, this trend's lower, this isn't what we think it is, what will that do to our overall ratio? And use that as a sanity check. So I hope that was useful. Let's get back to work.