Dear Startup Investor,

Buck Jordan here, and I want to wish each one of you Happy New Year! I Hope you celebrated the end of 2021 and the start of a new year in style.

A new year brings new investing opportunities, and the good news is entrepreneurs keep innovating and building no matter what time of year it is. After an exciting 2021 of opportunities, I’ve got my eyes set on these areas in 2022 while keeping these major investing risks in mind for the next 12 months.

In the past, I’ve shared some of the different tools and frameworks I use to analyze startups. So, when I’m evaluating a startup, I look at a lot of different factors. For example, I’ve developed my own framework over time, and every single angel investor needs to develop their own unique approach. However, of all the things I analyze when looking at a new investment opportunity, one of the most important factors is the unit economics of a startup’s business model.

The unit economics of a startup is one of the single most important factors to assess when it comes to potential investment opportunities. A startup’s unit economics have huge implications for a large range of downstream considerations, including determining how a company is valued, how fast it can grow and how competitive it will be against other players in the industry.

What are Unit Economics?

Unit economics are a measure of the profitability of selling one unit of your product or service to an end customer. Put in another way, unit economics refer to the direct costs and revenues related to delivering a marginal unit of a product or service. How much does it cost to provide this service? How much revenue does the product generate? What is the gross margin? These are all questions that are answered by a proper understanding of a business’ unit economics.

At the most fundamental level, the goal of unit economics is to measure a business and understand its business model on a per-unit basis – at the level of an individual good or service. This unit could be a car, a haircut, a hotel stay, a massage, etc. Each of these are the basic units provided by different types of businesses. Today, there are a number of different approaches to calculating unit economics, but two are most prominent and most often used in the software-as-a-service (SAAS) investing world.

CLV to CAC Ratio

The most common approach to unit economics today is to measure the ratio between customer lifetime value (CLV) to customer acquisition cost (CAC). CLV is the total revenue generated by the average customer over their lifetime as a customer. There are a number of different ways to calculate CLV, typically varying by category of product and business model. This graphic from Netsuite helps explain the high-level principles behind calculating CLV:

The customer acquisition cost (CAC) is the direct average marketing costs related to acquiring a new customer. Similar to CLV, there are a range of different costs that go into calculating CAC, once again varying by category of product or service and business model. These costs include advertising costs, creative costs, cost of marketing or sales, and other similar inputs related to the cost of customer acquisition.

The ratio between CLV and CAC helps provide a deep understanding of the unit economics of a business. This ratio is critical because it helps illustrate how much a business can expect to pay to acquire a new customer and how much that customer is worth to that business.

This ratio can determine how much a business should invest in marketing in the short and long term, how many new customers a business needs to acquire to account for annual revenue churn and, overall, how efficient and sustainable a company’s business model is over time.

In my time, I’ve invested in a lot of SAAS businesses like AnnexCloud, Honeybook, Harri, and Bridg (which was recently acquired for $350 million). I’ve naturally been drawn to SAAS because of the amazing unit economics these businesses carry. SAAS businesses typically have very healthy LTV/CAC ratios, often reaching 20:1, 30:1 or more.

When businesses and people pick software, they very rarely churn, and software users often have a very long lifetime, producing great LTV/CAC ratios (as long as CAC is not too high). SAAS is extremely sticky, so much so that the founder of private-equity firm Vista Equity remarked, “software contracts are better than first-lien debt,” to illustrate how valuable and reliable SAAS revenue is.

What’s more, the health of the SAAS business model can be extended outside of just software.

We’re doing this with our work at Miso Robotics, Graze and Piestro, where we are pursuing a robotics-as-a-service model for our customers, charging them recurring monthly- or annual-subscription fees to cover the cost of the software, hardware and maintenance related to delivering our robotics services. Our goal with these businesses is to replicate the unit economics of SAAS businesses over time – and, better yet, beat them.

Payback period on CAC

Another oft-used measure of unit economics is calculating the payback period for CAC. This measure helps shed light on how long it takes for a customer to pay back the respective acquisition cost. This ratio is particularly useful in understanding how much new investment a business will need, how efficient it is in turning marketing spending into profitable revenue and how long that takes. The payback period on CAC is also critical to understanding a business’ cashflow cycle; as you know, cashflow is king when it comes to building a business.

Graphic from Finmark

Just like the CLV/CAC ratio, the payback period can guide numerous important business decisions, ranging from how much money to raise to the amount to invest into discounting and customer retention. In particular, shorter payback periods are particularly powerful for startups because they imply less working capital is needed on a per-customer basis, and, therefore, the company as a whole can grow revenue in a much more capital-efficient way than businesses with longer payback periods.

How to Apply this?

Typically, startups include preliminary LTV and CAC info in fundraising decks based on historical performance and forecasts for the near-term future. However, what if companies don’t provide these details?

Well, your first recourse is to ask questions in the comments of crowdfunding pages, one of the most useful features of different crowdfunding platforms. Generally speaking, the companies are very responsive to these questions.

However, if the company opts against sharing this information or their financials (or potentially doesn’t have definitive data on it yet), how should you proceed?

Your next step as an angel investor should be to find benchmarks of other businesses in the same category or industry to use as a point of reference. The best place to find these benchmarks is the public markets, where public companies are legally obligated to report detailed updates on the status of their business quarterly. Finding information on a per-unit basis can be difficult, and many public companies don’t report it. A safe fallback in this case is to use the gross-margin metric; almost all public companies report this data, or it can be calculated from other reported metrics.

What does this look like in practice? We’ve reviewed a lot of customer relationship management (CRM) startups from all over the world through the years at Wavemaker. We’ve also invested in several, including Mindbody. Whenever reviewing a new CRM startup, we immediately began searching for benchmarks to serve as reference for our analysis.

Fortunately, there are numerous CRM companies that are now publicly traded, including Salesforce, Hubspot and Freshworks to name a few. To find detailed information on each of these businesses you can search for their investor relations page on their website (such as Hubspot’s investor relations page). From there, you can review a range of information, especially their latest quarterly investor presentation, which is always rich in information.

Page 21 of this presentation discusses Hubspot’s unit economics and, specifically, their gross margin. We now know that Hubspot’s gross margin is 80%, and its operating margin is around 10%. We can compare the metrics of a startup we’re evaluating to the metrics of Hubspot – one of the best in-class examples. How do they compare? Are their metrics better, the same or worse? Are there good explanations for why there might be deviation?

You can repeat this process across different industries and business models to find your benchmarks as an angel investor. Other potential sources of information are free – or freemium – sources, such as PublicComps.com and Koyfin, where you can easily search for, and find, a range of metrics from different businesses.

As you evaluate new potential investments in 2022, understanding the unit economics of a startup is one of the most important components in evaluating a business’ strength. Building understanding at a per-unit level, or through higher-level measures like gross margin, is the foundation of building a deep understanding of a business.

You can build your understanding up from there to understand the company’s growth potential, financing needs, how they compare to competition, and numerous other factors. Understanding different businesses on a per-unit basis will also potentially help shape what types of businesses you are or aren’t interested in investing in. Whether it is SAAS, RAAS, haircuts or shoes, every business sells individual units of goods and services, and that is the best place to start when analyzing a business.

We’ll talk soon.

Buck Jordan