Unit Economics

What are unit economics?

Unit economics (in German roughly: Wirtschaftlichkeit je Einheit) are the revenue, costs and contribution margins of a business model, related to a single unit, usually a customer. The contribution margin is revenue less the costs that arise additionally with each unit. Unit economics show whether each additional unit brings in more over its lifetime than its acquisition and servicing cost, and thus whether growth improves or worsens earnings. A gym that pays for advertising for every new member earns money only when the member stays long enough to recoup these costs through the member's fees.

Investors ask about unit economics early in every funding round of growth companies. They appear in the investor presentation (pitch deck), in the financial model, in due diligence and in ongoing reports to investors. Three questions are at the centre: what it costs to win a customer, what the customer brings in over the entire contract term, and how long it takes until the acquisition costs are recouped.

The unit and its metrics

The unit is the smallest recurring quantity on which the business model earns. For subscription software, that is usually the customer or customer account, for marketplaces the single transaction, for branch concepts the location. Revenue and variable costs must be clearly assignable to the unit.

On this basis, five quantities are linked:

• average revenue per customer (ARPA, Average Revenue per Account)
• the contribution margin per customer, that is, this revenue less the variable costs, for example for servers, payment processing and customer support
• the cancellation rate (churn rate), from which the expected customer lifetime is derived
• customer acquisition cost (CAC)
• the customer value over the entire contractual relationship (LTV, lifetime value)

From them follow the two ratios that investors usually check first: the ratio of LTV to CAC and the payback period of customer acquisition costs.

Calculating unit economics: the formulas

Customer acquisition cost

Formula: CAC = sales and marketing costs of the period / number of new customers won in the period

The costs include, besides advertising spend, the salaries and commissions of sales, events, sales software and a proportionate share of management costs. A common distinction is between the overall view across all channels and the costs per channel. Because there are often months between spending and contract signature, a time lag is applied for longer sales cycles.

Customer value

LTV describes the contribution margin that a customer generates during the contractual relationship. The expected lifetime in months corresponds to the reciprocal of the monthly cancellation rate.

Formula: LTV = monthly contribution margin per customer × 1 / monthly cancellation rate

The calculation uses the contribution margin, not revenue. With very low cancellation rates, the reciprocal gives computed lifetimes of many years. In practice, lifetime is therefore capped, as a rule of thumb at three to five years, or the customer value is discounted, that is, later contributions are weighted less than early ones.

Payback period

The CAC payback period states after how many months the contribution margin of a customer has recouped the customer's acquisition costs.

Formula: payback period in months = CAC / monthly contribution margin per customer

For financing it is often more informative than the ratio of LTV to CAC, because it shows how long capital is tied up in each new customer. The longer the payback period, the more capital additional growth consumes before it pays for itself.

Significance in a funding round and due diligence

For investors, unit economics answer the question of whether additional capital in sales and marketing creates value or multiplies losses. Common benchmarks are an LTV to CAC ratio of at least 3 to 1 and a payback period of under twelve months. Such values are not fixed limits; they shift with contract terms, payment terms and customer segment.

In due diligence, the metrics are checked for their origin. Sales and marketing costs are reconciled to the income statement, cancellation rates are recalculated from customer vintages (cohort analysis), and the values are broken down by segment, channel and contract vintage. An average across all customers that cannot be broken down in this way is considered not very reliable.

Improving unit economics: the levers

• Cancellation rate: acts particularly strongly on customer value through the reciprocal. Halving the monthly rate doubles the computed lifetime.
• Price and additional revenue: raise the contribution margin per customer directly. Revenue from expansions of existing contracts improves the calculation without additional acquisition costs.
• Variable costs: for example infrastructure, payment processing and customer support. The room for manoeuvre is usually limited for software and greater for hardware and services.
• Customer acquisition: can be improved mainly through the channel mix, closing rates in sales and a focus on segments with shorter payback periods.

Worked example: unit economics by customer segment

A software provider wins 150 new customers in a quarter at sales and marketing costs of EUR 900,000. The monthly cancellation rate is 2% in both customer segments.

• Total CAC: EUR 900,000 / 150 = EUR 6,000
• Average contribution margin per customer and month across both segments: EUR 500 of revenue minus EUR 100 of variable costs = EUR 400
• Expected lifetime: 1 / 0.02 = 50 months; LTV: EUR 400 × 50 = EUR 20,000
• LTV to CAC: 20,000 / 6,000 = 3.3; payback period: 6,000 / 400 = 15 months
• Segment A with 100 small customers: costs EUR 500,000, CAC EUR 5,000; contribution margin 250 minus 50 = EUR 200; LTV 200 × 50 = EUR 10,000; ratio 2.0; payback period 25 months
• Segment B with 50 mid-sized customers: costs EUR 400,000, CAC EUR 8,000; contribution margin 1,000 minus 200 = EUR 800; LTV 800 × 50 = EUR 40,000; ratio 5.0; payback period 10 months

On average the company meets the ratio of 3 to 1 but misses the payback period of twelve months. Only the breakdown shows the cause: Segment B carries the business, while Segment A ties up EUR 5,000 per customer for more than two years. Concrete decisions follow, for example shifting the budget to Segment B, adjusting prices for small customers or winning them through cheaper channels. For the funding round, this means: growth in Segment B can be accelerated with capital, while growth in Segment A initially increases the capital requirement.

Distinction: unit economics, contribution margin, break-even and KPI

• Contribution margin: the basic quantity from which unit economics are built. Unit economics combine it with acquisition costs and lifetime.
• Break-even: the point at which the company as a whole covers its fixed costs. Positive unit economics are a prerequisite for it, but not sufficient, because fixed costs and growth pace are added.
• KPI: the umbrella term for management metrics. Unit economics are a group of metrics relating to the individual unit.
• Rule of 40: a metric for the company as a whole. It can be met even though individual segments show negative unit economics.

Common mistakes

• Revenue instead of contribution margin. A customer value on a revenue basis overstates each customer's contribution by the variable costs and flatters the ratio to CAC.
• Incomplete acquisition costs. If only advertising spend is captured, salaries, commissions and sales software are missing. CAC then appears far too low.
• Average across all segments. A healthy average can hide a segment that consumes capital with every new customer.
• Unlimited lifetime. With low cancellation rates, the reciprocal gives terms that no investor regards as reliable without confirmation from cohort data.
• Hoping for economies of scale. If the contribution margin per customer is negative, growth enlarges the loss. Economies of scale act mainly on fixed costs and hardly on the individual unit.

Frequently asked questions

When do unit economics have to hold up?

At the latest before sales and marketing are expanded with the capital of a larger funding round. Before that, the values may fluctuate, as long as it is evident that they improve with a growing data base. Anyone who grows with negative unit economics shortens the company's own runway without creating value.

How is a table for unit economics structured?

With one row per customer segment and sales channel. The columns contain new customers, sales and marketing costs, CAC, average revenue per customer, variable costs, contribution margin, cancellation rate, lifetime, LTV, ratio of LTV to CAC and payback period. A row for the overall average alone is not enough, because it hides weak segments.

How often should unit economics be recalculated?

At least quarterly, separately by segment and channel. A value determined once becomes outdated quickly, because prices, channels and cancellation behaviour change. Investors expect the figures to be updated in the ongoing reports.

What role does customers' payment method play?

A considerable one for the capital requirement. If customers pay the annual fee in advance, acquisition costs flow back faster than the monthly payback period suggests. Monthly payment, by contrast, lengthens the time for which growth has to be pre-financed.

Are unit economics also relevant in a company sale?

Yes. Buyers conclude from contribution margin, cancellation rate and acquisition costs how reliable recurring revenue is and how much capital further growth requires. Both feed into the multiple they apply to revenue or earnings.

The Roemer Capital view

In Lucas Roemer's book “Kapital folgt Struktur” (literally “Capital Follows Structure”), unit economics are, alongside runway, KPIs and governance, one of the four pillars on which investor readiness shows. A company is investor-ready if it is structurally able to grow disproportionately with external capital. Whether additional capital has this effect is shown by the unit economics. In mandate preparation, we therefore review them before we build up the revenue plan.

As a yardstick, we apply a ratio of LTV to CAC of at least 3 to 1 and a payback period of customer acquisition costs under twelve months, each separated by segment and channel. If a segment misses these values, we carry it separately in the financial model so that investors can see what their capital is used for.