Belle-V Kitchen is a consumer goods company I founded with several friends to bring to market high performing but beautiful kitchen tools. Although the products we make and sell are outstanding, at least in our opinions, the company has never been a wild commercial success. One of the problems with the business is that the unit economics and financial model are only marginally favorable. It’s sort of our own fault. From the outset, our analysis of the unit economics and financial model did in fact exhibit vulnerabilities, or at least reveal a pretty narrow path to success. This chapter may help you be disciplined enough to avoid a similar plight.

Every single business incurs some on-going costs associated with merely existing. For instance, virtually every business pays an annual fee to a government entity and pays something to maintain a postal address. Most businesses incur costs for insurance, telecommunications services, and accounting software. Many businesses rent facilities, pay utility bills, and hire administrative employees. All of these costs are called general and administrative costs or G&A under generally accepted accounting practices (GAAP). With a few tiny exceptions, all businesses also incur costs to generate demand for their solutions. I call these sales, marketing, and advertising costs or SMA. Technology-based businesses may also have significant research and development or R&D costs. Put together these costs are the on-going costs of operating the business, are incurred over time, and do not change immediately in direct proportion to the company’s revenue.

In order to achieve long-term financial sustainability, a company’s gross profit has to exceed the on-going costs of operating the business. Put simply, gross profit is the revenue customers pay the company minus the variable cost of delivering the solution. Here’s a simple example. If a bubble tea shop costs USD 120,000 per year to operate, then it must generate at least USD 120,000 in gross profit per year to remain in business indefinitely. If customers pay USD 6.00 for each serving of bubble tea and delivering each additional serving of bubble tea, including materials and labor, costs USD 2.00, then the shop must deliver 30,000 servings of bubble tea each year to sustain itself, or break even. That works out to an average of 577 servings every week.

Unit Economics

For a bubble tea shop, the selling price of USD 6.00 and the cost of delivering a serving of bubble tea of USD 2.00 are called the unit economics. Unit economics are the revenues and costs of a business measured on a per-unit basis, where a unit can be any quantifiable element that brings value to the business, such as a single quantity of a physical good sold, a single consulting engagement, or a single customer relationship. Analyzing the economics of a business at the level of a single unit informs managerial decisions about pricing and about the inputs to the solution and their costs. The unit economics also dictate the minimum number of units that the company must serve or deliver in order to break even. If the unit economics are not favorable, the overall economics of the business, which include its operating costs, can not be favorable.

Analyzing unit economics first requires selecting the unit of analysis. This selection depends on the characteristics of the business. Businesses vary on innumerable dimensions, including cost structure, distribution channels, frequency of transactions with customers, and the business’ role in a market ecosystem. These differences are reflected in the financial models of the businesses. Some require huge investments in research and development, but then enjoy high gross margins once the product is launched. Others operate on slim margins, but don’t require much selling expense once a customer is acquired. Still others offer an all-you-can-eat solution for a subscription fee. While no two businesses are identical, four different types of businesses emerge frequently enough and have distinct enough financial models that they warrant separate treatment:

1. Classic make-and-sell businesses (e.g., Belle-V Kitchen)
2. Low Marginal Cost Services (e.g., Quickbooks)
3. Social Networks (e.g., LInkedIn)
4. Marketplaces (e.g., Airbnb)

In this chapter, I describe these four types of businesses, the focal unit most appropriate for that type of business, and a common financial model associated with that type. Your business may fall between these categories, but almost certainly one of them will be pretty close, and will give you a template to start from.

Along the way I’ll introduce some more terms and concepts that are more generally useful, including these:

• Gross margin
• Marginal cost
• Cost of goods
• Target costing
• Minimum viable scale
• Customer lifetime value
• Customer acquisition cost
• Recurring revenue
• Gross merchandise value
• Take rate

Because I treat four distinct categories of businesses, this chapter is long. Life is short, so you may benefit from identifying which category is most relevant to your venture, and then focusing on that section below. However, I do introduce key terms and definitions as I go and don’t repeat them for each example, so if you are new to managerial accounting, you may benefit from reading the whole chapter.

1. Classic Make-and-Sell Businesses (e.g., Belle-V Kitchen)

Belle-V Kitchen is an example of a classic make-and-sell business. Such businesses simply produce a good and sell it to customers in a single transaction. The business may deliver a physical product like a bottle opener or a service like a restaurant meal. I write make-and-sell business, but some businesses are actually sell-and-make, in which the good is produced according to the specifics of a customer order, as with say Abodu Homes, a company providing prefabricated structures for use as accessory dwelling units in the United States. Regardless of sequence, these classic businesses follow a similar template.

The focal unit for a classic make-and-sell business is each instance of the product itself — the kitchen implement, the housing structure, a cup of bubble tea, or an excursion with a tour guide. In all cases, a classic make-and-sell business incurs significant marginal costs to deliver a unit of its solution to its customers. Let’s now drill down on the unit economics of classic make-and-sell businesses using the example of Belle-V Kitchen and starting with an explanation of the concept of marginal costs.

Cost, Marginal Cost, and Cost of Goods

The word cost is often shorthand for the accounting term cost of goods sold or COGS. These are the costs directly attributable to delivering the solution to the customer. In the case of Belle-V Kitchen, these are the costs associated with the manufacturing of the opener itself, as well as the costs of getting it to the point of distribution, fulfilling the customer’s order, and shipping the opener to the customer.

For classic make-and-sell businesses, costs are expressed on a per unit basis, but that unit cost typically assumes some batch quantity in manufacturing. For instance, Belle-V obtains openers from a factory in China that makes high-quality stainless steel kitchen implements for many premium brands globally. When ordered in quantities of 10,000 pieces per order, Belle-V can buy these openers from the factory for about USD 7.00 per unit.

Note that this factory price would be higher for an order of 3,000 pieces and lower for an order of 100,000 pieces. In analyzing unit costs, the entrepreneur makes an assumption about the approximate quantity that will be produced, often quantities that can reasonably be achieved in the medium time horizon, say after a year or so of operation.

That USD 7.00 factory price is just a portion of the COGS however. Here is the full list of elements that make up COGS, all expressed as USD per unit, assuming an order quantity of 10,000 pieces.

• manufacturing cost 7.00
• freight from factory to US warehouse 0.30
• duties paid to the US government 0.28
• labor to unload and store the inbound freight 0.02
• materials and labor to process, pack, and ship openers to a retailer
  (assuming a bulk carton of 36 pieces) 0.14
• scrap and warranty replacements (averaged over time) 0.10

Total Cost 7.84 (USD/unit)

Each additional unit sold incurs an average cost of about USD 7.84. This is called the marginal cost of the delivering the solution, because it is the additional cost “at the margin” of delivering one more unit.

Again note that marginal cost analysis implicitly requires an assumption about the quantities that will be ordered or produced. The business’ marginal cost might be a bit lower if it could order in much higher volumes in the longer term, and would be higher if it had to make openers just a few at a time, say while testing the market. For planning purposes, a financial model should explicitly state the embodied assumptions about order quantities, and analyze several scenarios, say for the modest expected quantities in year 2 and for larger expected quantities in the longer term, say in year 5.

Target Costing

For classic make-and-sell businesses, an important analysis is called target costing, which forces the manager or entrepreneur to bring anticipated selling price and estimated unit cost into coherence. This is the part we didn’t do so well with Belle-V Kitchen.

We planned for the Belle-V opener to be sold as a luxury gift and we originally expected it to be priced at USD 50 per unit in the store. We set this price by looking at other items in the store intended as nice gifts and by thinking about what the buyer’s alternatives for other nice gift items might be. We considered price points from USD 19 to USD 59. Setting your prices should be a deliberate exercise, and in established companies is usually coordinated among the business manager, marketing and sales managers, and the product manager. I’m not sure we were right in setting our price at USD 50. That’s a lot for a bottle opener, even a really nice one. In later years, we adopted a direct-to-consumer model at a lower price point. More on that below.

A target costing analysis works back from the price the product would sell for in the store to what the cost must be at the factory in order for the economic system to work for everyone.

Let’s first consider a typical retailing model, in which Belle-V sells on a wholesale basis to a store, that in turn sells to an individual consumer.

We anticipated a retail price of USD 50. However, the consumer isn’t giving us, the brand owner, 50 dollars. Instead, they’re paying the retail store 50 dollars. In order for the retail store to be in business, the retailer has to buy the product from us for quite a bit less than 50 dollars. In the Belle-V case, in which retailers are mostly specialty gift boutiques like museum stores, the retailer’s gross margin is typically 50 percent. That is, the retailer sells the opener to the consumer for USD 50, but pays us just USD 25. So, the retailer makes USD 25, or 50 percent of the selling price. 

Now we have to work back from the price we get from the retailer to what our target cost would be. To do that we need to think about what we as the brand owner need for gross margin. Let’s assume for now that our target gross margin is 40 percent. That is, on average we want the gross profit on each unit to be about 40 percent of the revenue we get from a sale of that unit.

Since we get USD 25 in revenue for each unit, the price the retailer pays us, we need to pay no more than 60 percent of that figure for the goods, or USD 15, in order to leave 40 percent gross margin, or USD 10.

Fifteen dollars is the maximum cost of goods we can pay in order for us and our retailer to earn reasonable margins and to sell the product to the consumer for USD 50. This arithmetic simply works backwards from the selling price to the consumer through the distribution channel, and accounting for the required margins at each step, in order to arrive at the maximum cost we could pay for each unit and still remain in business.

Incidentally, for consumer goods sold through specialty retailers there is a short-hand “rule of 4” that the end consumer price is four times the cost to get the product into the original brand owner’s possession. It’s a pretty good quick way to check the feasibility of making and selling a consumer good. A rule of 4 corresponds to two parties in a supply chain each earning 50 percent gross margin.

I want to now drill down on two additional points. One is the arithmetic to calculate gross margin. The second is where those gross margins come from — and what values are reasonable in practice.

Gross Margin

Gross margin is defined as the price minus the cost, divided by the price. This is always taken from the perspective of the entity that’s selling the product. So for instance if USD 50 is the price the museum store offers to the customer, and they pay us USD 25, then their gross margin would be 50 percent. That is, 50 – 25 (which is 25) divided by 50. And if instead they paid us USD 28, then their gross margin would be 44 percent – that is, 50 – 28 (which is 22) divided by 50. 

Note that gross margin is not the same as mark up. Mark up is defined as the price minus the cost, divided by the cost. So, if the retailer buys the opener from us for USD 25 and sells it for USD 50, then the mark up is 50-25 (which is 25) divided by the cost (which is 25) or 100 percent. Some industries use mark up and some use gross margin. Of course these two metrics are related arithmetically as follows: gross-margin = mark-up / (1+ mark-up), so you can convert from one to the other. I find it easier to always start with price and cost and then calculate gross margin or mark up from those two values as needed. From here on, we’ll use gross margin, as it is the more common term and because it directly drives an important metric in a company’s financial statements, gross profit.

What determines a reasonable gross margin for a retailer? First of all, volume. All else equal, the lower the volume of the retailer, the higher the margin the retailer requires in order to be able to stay in business. Just consider the difference between a grocery store that moves hundreds of thousands of dollars in volume every week compared to a jewelry store that might only sell one or two items a day. The jewelry store will require higher gross margin.

Second, the higher the price, the lower the gross margin, all else equal. Consider the difference between selling a new automobile and selling a hammer. The automobile will have a lower gross margin percentage.

The third factor is differentiation. All else equal, if your product is so special that you’re the only source of supply, then your gross margin will be higher than for a product with a lot of competitive alternatives.

The final factor is the costs that are required for the retailer to sell your product. Characteristics that increase the costs for a retailer selling your product are seasonality, service requirements, and the intensity of the sales process. The higher these costs, the higher the required gross margin for the retailer.

Now to put this all together just consider the difference between construction materials and luxury cosmetics 

Construction materials exhibit relatively low differentiation with relatively stable demand at relatively high price points in high volumes. Thus, they are going to be sold at quite low margins, maybe only 10 or 15 percent. Luxury cosmetics are the opposite on all of those dimensions, and thus retailers of those goods will likely expect margins of greater than 60 percent.

To give you a sense of a typical range, retailers of most consumer goods require margins of between 35 and 55 percent, but extreme examples, say building materials and luxury cosmetics may be outside of this range.

Now let’s turn to the question of what your target gross margin should be as the manufacturer or the brand owner.

A very similar set of factors drives the typical gross margin requirements for manufacturers. Higher gross margins correspond to some combination of high R&D costs, high selling expenses, high levels of differentiation, lower volumes, and high seasonality.

Manufacturers of consumer goods would expect to operate with gross margins between about 30 and 50 percent, but at the high end a brand owner for fashion apparel might have a gross margin of 75 percent or higher. And at the other extreme, auto makers might operate with gross margins of under 20 percent.

One good technique for estimating margin requirements is to study the income statements of public companies selling products similar to yours. These financial statements will give you their average gross margin, a useful benchmark.

Selling Direct

Often when the target cost analysis reveals either margins that are too tight, prices that are too high, or required manufacturing costs that are too low, the entrepreneur thinks, “No problem. We’ll cut out the intermediary and sell directly to consumers!” This is rarely a solution to lousy unit economics. That’s because in direct-to-consumer models, you can’t typically assume the other parameters for the business remain the same. There are three reasons selling direct is almost never a cure for marginal costs of production that are too high.

First, your unit cost will increase. For Belle-V Kitchen, here is how the unit cost changes assuming we sell direct to the consumer in individual quantities, and that we pay for the outbound freight associated with “free shipping.” Recall that our unit cost when selling to retailers is USD 7.84.

• manufacturing cost 7.00
• freight from factory to US warehouse 0.30
• duties paid to the US government 0.28
• labor to unload and store the inbound freight 0.02
• labor to process, pack, and ship a customer order (usually just one opener) 3.00
• carton, packing material, tape, and label (single unit) 0.40
• outbound freight paid to ship the opener to the end customer (single unit) 6.50
• scrap and warranty replacements (averaged over time) 0.10

Total Cost 17.60 (USD/unit)

Second, your volumes will likely decrease. The whole point of using a retailer for distribution is to make your product easily available where your customers expect to find it, and where they can see and touch the product. A bottle opener sold in the “big box store” Target will, all else equal, sell vastly more units than one sold only on a website of a start-up company. With lower volumes, your marginal cost of production may increase, which must be reflected in your analysis of the unit economics.

Third, you may incur higher selling expenses. You have to find and acquire the customer when you sell directly to consumers. For e-commerce retailers this often means paid advertising, which can be very expensive. Acquiring customers for consumer goods can cost USD 50 per customer or more depending on the level of competition for keywords used in advertising.

If we wanted to sell the opener directly to consumers for USD 29 and maintain a gross margin of say 60 percent to support our higher selling expenses, then our unit cost must be less than (1-0.60) x 29.00 = USD 11.60. That’s clearly not going to work, as our marginal cost of delivering an opener is USD 17.60. At that unit cost and a selling price of USD 29.00, our gross margin would be only 39 percent. That’s not enough for a direct-to-consumer housewares business. A price of USD 39.00 is closer to feasible, leaving a gross margin of 55 percent, still not wonderful. The reality is that Belle-V Kitchen couldn’t quite get the unit economics to work for this opener when selling direct to consumers.

Minimum Viable Scale

Most pro forma financial analyses for start-up businesses are fantastic fables, representing a big success scenario. It’s good to have hopes and dreams and to envision paradise. However, I believe you also benefit substantially from knowing what the business looks like at its minimum viable scale. By minimum viable scale, I mean the number of units sold or customers served per time period such that you can achieve positive cash flow. At least two factors tend to dictate this scale.

First, what is the minimum required level of staffing and business services that you need to operate. For instance, you might need a minimum of a general manager (perhaps you), a customer service representative, a sales and marketing person, and a production or fulfillment staffer or two. You might need a physical location and to pay some rent. You will likely need an internet connection, some insurance, utilities, and bookkeeping services. Add all that up and that’s the minimum on-going operating costs of your business. Now, what is the number of units sold or customers served per time period (e.g., month or year) to break even relative to those operating costs. That is one indicator of the minimum viable scale.

Second, are there some natural minimum batch sizes and order frequencies that are required to sustain the business. For instance, for Belle-V kitchen, we need to buy a minimum of 3000 pieces per order from the factory and we need to place an order at least annually to sustain that factory relationship. Therefore, it’s not really possible to imagine the business surviving if it can’t sell at least 3000 units per year.

Put those two factors together to estimate what the business would need to look like to remain in operation and to sustain positive cash flow. Every business is unique and every entrepreneur has a different threshold for what is truly minimally viable. Still, by considering these two factors you can estimate a minimum viable scale for your situation. The resulting scale is of course not your goal. It’s instead a realistic assessment of what level of success you must achieve in order to live to fight another day. I like to think about the entrepreneurial journey as a long ocean swim. You’re setting out from the beach on a sunny day. You can see what you believe to be a beautiful tropical island off in the distance. That’s your goal. But, what happens if the wind picks up, or the water gets choppy, or your leg cramps? Is there a smaller island where you can rest and recover? How far out is it? That’s your minimum viable scale.

Putting Unit Economics Together in a Financial Model for Classic Make-and-Sell Businesses

Here’s a process for understanding your unit economics and creating a financial model for a classic make-and-sell business.

• Decide on your distribution and channel configuration (e.g., direct to consumer vs. selling through retailers).
• Set a target price to the end customer based on the competitive situation and the value of your solution to the customer.
• Estimate your target cost by assuming gross margins for you and for your distribution channel. For a good first estimate, base these gross margins on typical margins for similar companies in your industry.
• Check your costs to be sure your marginal cost of production is well below your target cost estimate.
• Estimate the on-going costs of operating your business, and then use your gross-margin estimate to do a break-even calculation for the number of units you need to sell per time period to sustain your business.
• Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro forma income statement for the minimum viable scale. These two financial models represent your goal as well as your fall back position should things go much worse than planned.

2. Low-Marginal-Cost Services (e.g. Quickbooks)

Many important businesses deliver services with very low marginal cost, sometimes close to zero. For example, a business that sells templates for legal documents may deliver its solution as a digital download. The marginal cost of delivering ten documents per day or ten thousand documents per day is essentially the same, and essentially zero.

One warning. Be careful about assuming your cost of goods is zero for all digital goods. For instance, content businesses like Netflix deliver a digital good, but they pay the original content creator for that content, often in proportion to the number of times it is delivered. In such cases, the marginal cost of delivering a solution is significant. In a second example, many AI-based businesses require expensive cloud computing resources each time a customer makes a query. These are real marginal costs of production.

Two approaches to analyzing unit economics for low-marginal-cost businesses are common. First, if the solution will be used infrequently by the target customer, then the unit of analysis may be the product itself, say the delivery of a single document template. In that case, the unit of analysis is a single transaction and the gross margin is nearly 100 percent. Breakeven calculations can be done exactly as with make-and-sell products, considering how many transactions must be completed to generate enough gross profit to cover the on-going operating costs of the business. The only difference from make-and-sell businesses is that the gross margin per unit is essentially the sales price per unit, as there are no significant marginal costs of production.

Second, and perhaps more typically, products with low marginal costs are priced on a subscription basis per customer, or possibly per user when there are multiple users per customer. This is especially true for products that are consumed intermittently but repeatedly over time. Examples of such products include Zoom, Adobe Acrobat, and Quickbooks. They are all priced on an “all you can eat” subscription basis. Most of these products are delivered over the internet as software as a service or SaaS. For simplicity I’m going to focus on SaaS products in further elaboration. For SaaS products, the unit of analysis is most commonly the customer, not each use of the product.

Customer Lifetime Value (LTV or CLV)

The most important metric in SaaS unit economics is customer lifetime value (LTV, or sometimes CLV or even CLTV). LTV in turn is driven by just two factors: churn and revenue per unit time.

Even a very sticky product like Quickbooks experiences some loss of customers over time. This loss is called churn, and is expressed as a percentage of the customer base that is lost in a given time period. Put another way, over a given period of time — say one year — what is the probability that a customer will cancel their subscription for use of the product? Some products, like Quickbooks, have very low churn, say less than 10 percent annually. Others, like video streaming service Disney+ have very high churn, perhaps 10 percent each month. (Admit it, you’ve subscribed just to watch a new series, only to quickly cancel when done.)

Churn can be thought of empirically and retrospectively — what fraction of our customers cancelled subscriptions last month, or it can be thought of as a probability about the future — what is the chance that a customer cancels in the coming month. Either way, churn is expressed as a percentage per unit time, say 15 percent per year, or 2 percent per month, using whichever time period best matches the pace of the business. Enterprise SaaS companies tend to use years and consumer SaaS companies tend to use months.

Note that the average duration of a customer relationship is simply 1/churn. So, for instance if your churn is 10 percent per month, then the average customer is with you for 1/0.10 = 10 months.

Revenue per unit time is just the average subscription fee your customer pays, say USD 15 per month. Armed with churn and average revenue per unit time, we can calculate LTV. In fast-paced environments like SaaS, the LTV calculation is usually kept pretty simple. Just multiply average duration times average revenue per period. If the average customer is with you 10 months and if subscription fees are USD 15 per month, then LTV is 10 x 15 = USD 150.

Of course, if the customer relationship lasts a really long time, and if pricing is expected to change over time, then LTV can be calculated as a net present value. A simple way to do that is with a spreadsheet in which the columns represent time periods out into the future. For each time period, consider the expected fraction of the customer that will still be with you (1-churn x the expected fraction of the customer you had in the previous period) and the expected subscription revenue. Then, discount the expected cash flow to the present using a discount rate (usually your opportunity cost of capital). More complex models of LTV can include factors such as additional products or services that a customer will buy on average in the future.

We’ve considered LTV in the context of low-marginal-cost goods offered on a subscription basis, but LTV can also be used for other settings in which a customer makes repeated purchases over time, say for a neighborhood coffee shop, where the average customer may make one purchase per week and where the churn is 2 percent per week. In such cases, the revenue per time period is not a subscription fee. Rather it is the average gross margin per transaction times the average number of transactions per time period. For example, if the coffee shop earns USD 3 in gross margin per transaction, thus generating USD 3 per week in gross margin, and keeps customers for an average of 1/0.02=50 weeks, then the LTV is 3 x 50 = USD 150.

Customer Acquisition Cost (CAC)

In a world of perfect information you could line up all your customers and know for each customer how they learned about you and what factors caused them to give your product or service a try. Then, you could estimate what you spent to create each of those factors, thus estimating for each customer their customer acquisition cost (CAC, pronounced “cack”). 

In reality you rarely know this information with much precision. Sometimes all you know is what you spent on sales and marketing for some time period, say a month or quarter, and how many new customers you acquired. You can then do a simple quotient to calculate your CAC. Say you spent USD 10,000 for the month and acquired 200 new customers. In that case, your average CAC is 10,000 divided by 200 or USD 50 per customer. 

Often you can get a more useful estimate by identifying how many customers were acquired via a particular mechanism and what that mechanism cost. For example, if you can discern via the analytics associated with an e-commerce site how many customers were acquired by pay-per-click advertising and you know what you spent on such advertising, you can estimate average CAC for the pay-per-click channel. This more refined estimate by acquisition channel allows you to take managerial actions to increase spending on more efficient channels and reduce spending for those that are less efficient.

Ratio LTV/CAC

In theory you could stay in business with LTV just barely exceeding CAC. But, most businesses aim to acquire customers at a cost of less than a third of LTV, and preferably much less. For example, for MakerStock, a business I co-founded that provides materials and services to designers, fabricators, and creators more generally, the customer lifetime value is about USD 300 per customer and we aim to acquire customers for an average CAC of less than USD 50, giving us a ratio of LTV to CAC of 6.

I believe that there are at least two reasons that in practice the target ratio of LTV to CAC is set to be at least three, and preferably much higher.

First, managers and especially entrepreneurs tend to be optimists, and reality rarely proves as rosy as their forecasts. Perhaps by setting a high bar we are more likely to achieve sustainability. If the target ratio of LTV to CAC is 6, then maybe we’ll hit 4 in reality, which would still work out.

Second, most measures of CAC are averages across a large number of customers. Averages hide the fact that some customers are much more expensive to acquire than others. By using a low average value for CAC as a target, we can be more confident that the most expensive customers, our marginal customers, are still being acquired for less than what they are worth to us.

Some other heuristics are useful in managing unit economics for businesses with repeat customers. Randy Goldberg, co-founder of Bombas, a direct-to-consumer apparel company known especially for great socks, told me that he aims to break even on a customer’s first order, so that CAC is less than or equal to the gross margin on that order. (A link to that interview is in the notes at the end of the chapter.) Then, all repeat business contributes gross margin above and beyond the acquisition cost. Of course we can conjure up examples in which that heuristic is not great (e.g., it won’t work if there is little repeat purchase), but it’s quite useful in its concreteness, simplicity, and ease of measurement. What did we spend to acquire customers? How many new customers tried our solution? What was the gross margin contribution of those new customers? If the gross margin from new customers is greater than what we spent to acquire customers, then we are probably not spending too much on sales, marketing, and advertising.

Recurring Revenue

Investors love SaaS businesses because of their recurring revenue. The product is usually delivered as an “all you can eat” solution with a per-period subscription fee. For instance, at this writing, the small-business accounting solution, Quickbooks, is priced at USD 30 per month for the basic, single-user plan. The beautiful thing about this business is that once customers have been acquired and are using Quickbooks, they are unlikely to stop subscribing until the business changes substantially because of winding down, acquisition, or enormous growth and the adoption of a more comprehensive solution. Because delivering the solution requires almost zero marginal cost, the leaders of Quickbooks can just think about subscription revenue as gross profit. (There are some marginal costs of the solution, such as operating the customer service function and some data hosting and computing requirements, but gross margins for such businesses are so high, often 90 percent or greater, that revenue is a reasonable proxy for gross profit.)

Recurring revenue is usually expressed as annual recurring revenue (ARR) or monthly recurring revenue (MRR). Recurring revenue, particularly ARR, is commonly used as a basis for valuing SaaS businesses in mergers and acquisitions or initial public offerings. ARR and MRR are usually calculated simply as the revenue per period from customers that are enrolled in subscription-based services and thus pay recurring fees. In businesses with extremely high churn, this revenue will of course not recur if nothing is done to replace those customers that churn in each period.

Putting Unit Economics Together in a Financial Model for Low-Marginal-Cost Businesses

Here’s a process for understanding your unit economics and creating a financial model for a low-marginal-cost businesses, particularly SaaS companies.

• Set a pricing guide, probably including different categories of customers. Many SaaS businesses offer free options and then set pricing tiers based on features and service levels. These are called freemium models.
• Estimate the average revenue per period per customer. This may require estimating the fraction of customers that will fall into each pricing tier.
• Estimate churn, either based on existing customer behavior, or based on benchmarks for similar businesses. Using this value for churn, calculate the average duration of customer engagement as 1/churn.
• Calculate LTV as the duration of customer engagement times the average revenue per customer per period. (If your business does have significant marginal costs of production, then use average gross margin per customer per period instead of revenue.)
• Estimate your CAC, either based on experiments you have done or on benchmarks from similar businesses.
• Check that LTV/CAC is greater than three, and preferably much greater. If LTV/CAC is not much greater than three, then you likely don’t yet have a feasible financial model.
• Estimate the on-going costs of operating your business. For SaaS businesses, software development costs and sales and marketing expenses are likely the largest elements of on-going cost. Use your estimate of revenue per customer per period to do a break even calculation for the number of customers you need to serve to sustain your business.
• Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned. For SaaS businesses, you can also estimate ARR for this scenario, which will likely be an important measure of the value of your business.

3. Social Networks (e.g., Instagram)

For social networks, the economic model is rarely as simple as for a classic make-and-sell business in which a discrete unit of product or service is provided in exchange for cash. Instead, two broad methods of monetization of the network are typically adopted.

First, the operator of a social network charges members a time-based subscription fee for use of the network. Because social networks increase in value with the size of the network, the initial fee to join the network is usually low or possibly zero. Then the provider charges a fee for continued use beyond a trial period or for additional features. Such monetization methods are called freemium models, because a free option induces joining and initial use, and then premium option are available as an upgrade for which a user pays a subscription fee. For instance, joining LinkedIn is free. To enjoy the ability to send messages to those outside of the members’ immediate connections requires a paid subscription.

A second monetization model is the sale of access to the social network to other businesses for complementary purposes. The most common complementary purpose is advertising, for which a second category of customer, usually businesses, may pay to reach members of the network with advertising. This is the primary monetization model for Facebook and Instagram. Complementary purposes other than advertising are also possible. For instance, data generated from the network may be valuable to third parties who will pay for access to it. Businesses may pay for direct access to members of the network, as when recruiters use LinkedIn to identify job candidates. As the saying goes, if you as a user are not paying to use a solution, you are not the customer — you are the product.

The unit of analysis for a social network is primarily the active user. There is no standard definition of active, but some common variants are daily active users, weekly active users, and monthly active users, which typically include those users of the social network who have engaged with the product in the specified time period. Secondary units for the purposes of understanding unit economics may be the paid subscriber and/or the business customer that pays for complementary solutions like advertising.

The unit economics for monetization via subscription are similar to those of SaaS businesses. What is the average revenue per customer per time period and how long does the average customer pay a subscription fee? The average revenue per customer is the fees paid in each subscription tier, weighted by the fraction of customers in each tier. For instance if there is a free plan and a plan for USD 15 per month, and if 80 percent of customers are on the free plan and 20 percent pay subscriptions, then the average revenue per customer per month is 0.80 x 0 + 0.20 x 15 = USD 3.00. Average customer duration, as in SaaS, is simply 1/churn. So, if 5 percent of active users churn each month, then the average duration of paid customer engagement is 1/0.05 or 20 months. Putting that together, the customer lifetime value (LTV) would be 20 months x 3 USD/month-user = USD 60 per user. Monthly recurring revenue (MRR) would simply be the number of active monthly users times the average revenue per customer per month, so if the network has 100,000 monthly active users, then MRR would be 100,000 active users x 3 USD/active-user-month = USD 300,000 per month.

For start-ups, estimating the fraction of active users that will pay a subscription fee is probably the result of an educated guess at first. However, the rates are typically quite low, often less than 2 percent. This fraction is likely a critically important parameter, so some benchmarking of subscription rates in the freemium models of related businesses will be highly informative.

For the second monetization method — businesses paying for complementary products and services — the unit of analysis will be the paying third-party customer. For this scenario, the unit economics are exactly as for a low-marginal-cost product like SaaS. You may price per unit of use, as with advertising, or you may price as an all-you-can-eat subscription. In some cases, as with display advertising, the revenues paid by third-party businesses may depend on the number of active users in the social network. In this case, you may be able to express the potential third-party business revenue as a value of each customer in the social network.

Putting Unit Economics Together in a Financial Model for Social Networks

Here’s a process for understanding your unit economics and creating a financial model for a social network.

• Decide on a primary monetization model — user subscriptions or third-party fees for access to the platform, such as advertising. In the long run, you may use both models, but typically one or the other will be your initial focus.
• If your primarily monetization model is user subscriptions then your user is your unit of analysis. If your primary monetization model is third parties who will pay for access to members of the social network, or for data related to the network, then your third-party customer is the unit of analysis.
• Establish price tiers. Estimate the fraction of users or customers that will fall into each price tier, informed by industry benchmarks.
• Estimate the average revenue per period per customer, based on a weighted average of the prices for each pricing tier.
• Estimate churn, either based on existing customer behavior, or based on benchmarks for similar businesses. Using this value for churn, calculate the average duration of customer engagement as 1/churn.
• Estimate LTV from average revenue per period per customer and on average duration of customer engagement.
• Estimate your CAC, either based on experiments you have done or on benchmarks from similar businesses.
• Check that LTV/CAC is greater than three, and preferably much greater. If LTV/CAC is not much greater than three, then you likely don’t yet have a feasible financial model.
• Estimate the on-going costs of operating your business. For social networks, software development costs are likely the largest element of on-going cost. Use your estimate of revenue per customer per period to do a break even calculation for the number of customers you need to serve to sustain your business.
• Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned. For SaaS businesses, you can also estimate ARR for these scenarios, which will likely be important measures of the value of your business.

4. Marketplaces Connecting Suppliers and Consumers, Sometimes Accompanied by Related Solutions (e.g., Airbnb)

Airbnb is an example of a marketplace, connecting suppliers of short-term housing with consumers of short-term housing. Other examples of marketplaces include eBay, Stubhub, and OpenTable. Marketplaces are also called two-sided markets because they serve two very distinct sets of customers: suppliers of goods and services and consumers of those goods and services.

Sometimes a marketplace is a component of a larger service offering that the organization provides directly. For example, the SaaS company Shopify provides software for operating an e-commerce storefront, but it also provides an app store with third-party solutions for merchants, such as freight calculators or sales tax collection systems. The core solution is the e-commerce SaaS, but a key element of that solution is a marketplace connecting suppliers of specialized application software to merchants who use that software as part of Shopify’s solution.

Occasionally a business that is primarily a marketplace will also directly offer ancillary services. For instance, Doordash is a marketplace connecting restaurants with hungry consumers, but it also directly operates a delivery service (“dashers”) that pick up and deliver the food. In such cases, the company may actually be operating a three-sided market (e.g., the restaurants, the diners, and the freelance delivery people).

Gross Merchandise Value and Take Rate

For marketplaces the unit of analysis is usually the transaction. The sum of all transactions over a time period is called the gross merchandise value (GMV). The marketplace charges fees to sellers, and sometimes buyers.

For most marketplaces, GMV is not a GAAP-compliant measure of revenue, as it does not reflect the actual amount of money that the marketplace earns from transactions. GMV may be used as a supplemental metric to indicate the size and growth of the marketplace, but it should not be confused with revenue. Revenue is the amount of money that a marketplace actually receives from its customers for providing goods or services.

The fraction of GMV that the marketplace retains as revenue before passing on the revenue to the supplier is called the take rate. For example, Airbnb’s GMV for its homes segment in 2023 was USD 29.4 billion, but its revenue from that segment was USD 7.3 billion, corresponding to a take rate of 7.3 / 29.4 = 24.8 percent. Note that Airbnb’s transaction fee on the booking is closer to 15 percent, but it charges several other fees to both hosts and guests so that when taken together the take rate is closer to 25 percent.

Take rate is largely determined by the market power of the platform. Marketplaces have very strong network effects, which can create huge sources of competitive advantage. Airbnb essentially crushed its rivals VRBO, Homeaway, and others in the period 2010-2020 becoming the dominant marketplace for temporary housing. This gives Airbnb substantial pricing power and allows it to earn a take rate of 25 percent. The Apple App Store charges a 30 percent fee for all transactions associated with digital goods made with an iOS app. The fees are lower for small businesses, for physical goods, and for multi-year subscriptions. However, put together, Apple’s take rate is also close to 25 percent. These values of 25 percent or a bit more are about the highest exhibited in practice. Marketplaces with less pricing power or dealing in physical goods have much lower take rates. For instance, eBay’s take rate in 2022 was about 13 percent. The practical range in take rates is typically 10 percent to 30 percent, with most marketplaces operating in the range of 15-20 percent.

Putting Unit Economics Together in a Financial Model for Marketplaces

The basic financial model for marketplaces is comprised of the GMV, the take rate, COGS, and on-going operating costs.

• Identify the two sides of your marketplace, likely suppliers of goods or services and consumers of those goods or services. Decide which side will pay for access to the platform, or possibly if both sides will pay. Use competitive benchmarks and a subjective evaluation of your relative pricing power to estimate your take rate, expressed as a percentage of GMV.
• Estimate your cost of goods, the direct costs of executing transactions, which may include fraud protection, customer service, and computing resources. For most virtual marketplaces, COGS is a small percentage of revenue. For example, Airbnb’s COGS for 2022 were $1.5 billion, which included expenses such as payment processing, customer support, trust and safety, and host insurance. Airbnb’s gross profit for 2023 was therefore USD 6.9 billion, 82% of its revenue.
• Estimate the on-going costs of operating your business. For marketplaces, software development costs and sales and marketing costs are likely the largest element of on-going cost.
• Revenue is simply GMV times take rate. Then, gross profit is revenue minus COGS. To achieve financial sustainability, gross profit must exceed on-going operating costs. The breakeven value can then be estimated in terms of GMV, which can be translated into a number of transactions by assuming an average transaction value. Calculate the break even number of transactions and associated GMV you will need to achieve per unit time to meet your on-going operating costs.
• Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned.

Notes

Fader, Peter, and Sarah E. Toms. The Customer Centricity Playbook: Implement a Winning Strategy Driven by Customer Lifetime Value. Wharton School Press, 2018.

Interview with John Geary, co-founder of Abodu Homes.

Interview with Randy Goldberg, co-founder of Bombas.