Each week, the Foresight team spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. The first installment deals with modeling Unit Economics for your early stage business.
Question:
How Do I Model My Unit Economics?
One of Foresight’s startup clients recently approached us asking for advice on how to model the Unit Economics for 2 different business models that the company was considering. The client is launching an Airbnb-type venture and weighing the pros and cons of a Subscription model and Commission model. Although the 2 business models are very different, the Unit Economics modeling is fairly similar, with the largest difference being the Monthly Recurring Revenue (“MRR”) component.
Answer:
- Identify the Unit
The first step to modeling Unit Economics for a majority of (if not all) businesses is to identify the Unit. The Unit is the revenue generating component of your financial model. For a Consumer Software/Subscription business (i.e. Spotify, Microsoft Office 365, etc.), the Unit is likely a single subscriber. Conversely, for Enterprise Software-as-a-Service (SaaS) businesses (i.e. Salesforce, Workday, etc.), the Unit may be an entire organization with many users. In any case, the best starting point for thinking about your Unit may be identifying your “average customer.”
In the case of our client’s Airbnb-type business, the answer is somewhat counter intuitive. The Unit in both cases, Subscription and Commission, is not the end-consumer (the people using the platform to rent). Instead, the Unit is the “Host” – the owners of the assets that are listing their property on the platform. This is because the Hosts are ultimately driving revenue for the business, either through monthly subscription fees or by sharing a portion of their rental proceeds.
- Determine Your Customer Acquisition Cost (CAC)
Once you’ve identified your Unit, the next step is to determine how much it will cost your business to “acquire” them. By definition, for your Unit Economics modeling it is important that you isolate the cost to acquire and onboard a single Unit. There are commonalities among almost all businesses that will be included in your CAC, such as sales expenses, marketing expenses and salaries, but it is also important to consider less-obvious costs that may be more unique to your business, such as data hosting expenses, legal fees, etc.
Again, since the Unit was consistent for our client across both business models, the components of the CAC were also consistent. However, differing business models have significant implications for the CAC that are important to consider. In this case, the Marketing Expenses required to acquire a Host under the Commission model are likely much less than the expenses under the Subscription model. At the most basic level, this is because the costs to acquire a paying user is typically far greater than the costs to acquire a free user.
- Calculate Monthly Recurring Revenue (MRR)
The MRR for your Unit Economics model is another critical input that looks at the amount of revenue that your business collects from each Unit on a recurring basis. The simplest determination of MRR is for a subscription business with a single subscription tier. If the business only offers 1 subscription level, to 1 type of customer, then the MRR is equal to the monthly subscription fee. The MRR calculation becomes more detailed as you begin to add additional subscription tiers, different types of customers, add-on features, etc. In these cases, you should again undertake the exercise of determining the characteristics of your average customer, and calculate the recurring revenue generated based on these features.
For our client, MRR is the component of the Unit Economics model that differs the most between the 2 business model options. For the Subscription model, the determination of MRR is again fairly simple – it is equal to the monthly subscription fee that the average Host will pay to list their assets on the platform. For the Commission model, however, the calculation becomes much more involved. Because the revenue generated from the Unit under the Commission model is not uniform or guaranteed, many assumptions need to be made about the transactions. These assumptions include Average Transaction Size, Average Number of Transactions per Month, Average Number of Listings per Month, etc. From this example, it is clear how quickly the MRR calculation can complicate.
- Know Your Industry Benchmarks (Churn Rate)
Particularly in the early stages of your business and Unit Economics modeling exercise, it is important to be acutely aware of your industry benchmarks. For inputs such as CAC and MRR, although each business will have unique values, it should raise a “red flag” if your inputs are orders of magnitude away from what similar companies are reporting. If solid justifications exist for your deviation from industry norms, proceed with your modeling but be prepared to answer questions about the abnormalities.
While CAC and MRR are determined using internal inputs and assumptions in conjunction with industry benchmarks, Churn Rate (“Churn”) will come exclusively from benchmarks for all new companies. Churn is defined as the percentage of customers that you lose each month. In the early stages of your business, you simply lack the operating history to know how “sticky” your service is, so instead you should turn to the market to tell you how frequently customers leave (unsubscribe, cancel, become inactive, etc.) similar platforms.
Using these 4 steps as a starting point, you should be well on your way to constructing a solid Unit Economics model. This will become the foundation of your Financial Model as a whole, and help you determine your specific funding requirements among many other key details about your business. For a more in-depth explanation and example of Unit Economics modeling, check out Foresight President, Efrat Kasznik’s talk titled “Telling Your Story with Numbers,” and register to attend one of our upcoming talks!